Corporate Governance Issues

Reward for Failure

Much attention has been paid to excessive pay increases and bonuses for senior executives, especially where these appear to be awarded regardless of the corporate performance achieved.

Criticism of directors for receiving massive bonus and termination payments typically happens when there seems to be an element of reward for failure. UK directors in the FTSE 100 companies are paid more than in the rest of the FTSE companies, but they do not receive the massive sums seen in Fortune 500 companies in the United States. There is a tradition of higher rewards in financial services. A big bonus culture existed in financial services among those dealing in the markets, as well as in the boardroom. Whether this was a cause of the recession is not yet clear, but it may have increased the propensity of managers and traders to take higher risks.

For most directors in the United Kingdom, pay and bonus awards were marginally reduced in the period from 2003. There are a number of possible reasons. Some companies have reduced notice periods for chief executives to around 12 months, which has encouraged more reasonable termination payments. Stockholder activism among both institutional stockholders, such as the Association of British Insurers, and small stockholder groups means that stockholders are likely to be consulted before new schemes are introduced. The court of public opinion is assisted by a vigilant press and the transparency rules. Accounting rules are now generally applied that require the cost of stock options and LTIPs to be fully expensed in the accounts. Increased volatility in share prices and the massive fall from the last quarter of 2008 onward have made stock options much less attractive, so there is less likelihood of big payouts at a later time when the executive cashes in the shares.

Base pay and total rewards are typically decided according to the market capitalization, the total number of employees, and the financial turnover of a business with respect to its industry comparators, but they are also, of course, contractually negotiated. Pressure from institutional investors and the press/media has created interest among the general public in this area, fueled by a number of high-profile cases where corporate failure has not been reflected in reductions in bonus or reward. As a consequence, director-level rewards are now very highly regulated and scrutinized compared to other employee groups.

Remuneration Committees

There is a convergence in corporate governance arrangements, based on the principles of transparency, the need to justify pay awards, the independent judgments of a remuneration committee, an accent on the process rather than on the content of rewards, and compliance with the rules as a condition of being listed on the appropriate stock exchange. Some of these principles were found in the original voluntary rules of the stock exchanges (for example in the Combined Code of the London Stock Exchange). Statutory provision has reinforced these rules—Directors’ Remuneration Report Regulations 2002 (UK), Sarbanes–Oxley 2002 (US), SEC rules (US), NRE Act 2001 (France), and in Germany, the Cromme Code (2002). The UK regulations of 2002 require listed companies to have a remuneration committee of independent (nonexecutive) directors, which must produce and publish a report as part of the annual company report. This must include a statement of reward policy, the role of the remuneration committee, proposals for directors’ pay going forward, and must include a graph showing comparisons in terms of TSR with a named broad equity index over the previous five years, stating the reasons for selecting the index. Stockholders must be given the opportunity to vote on the remuneration committee report at the AGM. The stockholders’ vote is not binding, but it would be unusual for a company and CEO to implement a pay award to the directors if this was voted down.

Making It Happen

Effective reward policies for senior managers and directors can only be created if there is a clear line of sight between their performance goals and the business objectives. This requires:

strategic planning and accurate budgeting;

clear accountabilities, cascaded down the business;

realistic, measurable, demanding performance targets for the short and long term.

Job evaluation techniques such as the Hay system can help to review accountabilities systematically.

Base pay should be decided from market data on rates, with comparator organizations in the same industry sector that have similar market capitalization and employee numbers.

Variable pay is used to recognize and drive performance. Short-term performance will need bonus schemes to be designed with annual performance targets, and there are design decisions to be made about whether there should be a threshold performance level, any weighting on particular targets, etc. Bonus is normally a percentage of base pay (typically 20%–40%). Long-term incentives might include a deferred bonus paid out after two or three years, with further performance conditions attached, and/or stock option schemes.

Decisions on rewards are made by remuneration committees for director-level pay in quoted companies, with annual public reporting and stockholder involvement.